Light at the end of the tunnel

After more than a year of denial, misdirected policies and a steadily worsening outlook, the past fortnight has witnessed a marked improvement. For the first time, there are reasons to be cautiously optimistic that the economy faces a recession rather than a prolonged slump, and recovery could get underway in H2 2009.

Markets share some of that optimism. The Dow Jones Industrial Index has risen 15.5% over four consecutive sessions, the most sustained rally since April 2008. It is not yet time to break out the champagne. But there are reasons to start looking through short-term weakness to focus on an eventual, albeit modest, recovery by the end of next year.

Denial and misdirection

Regulators and much of the financial services industry have been in denial for more than a decade about the steady accumulation of risk within individual institutions and across the system as a whole.

Even when rising defaults on subprime loans caused the music to stop last summer, regulators and industry leaders failed to appreciate the structural nature of the crisis. There was much talk of isolated instances of poor risk-management and hope the downturn could be contained in the housing market and motor manufacturing.

Most thought the music would begin playing again after a brief pause, and the dance could resume much as before with only a few minor modifications.

As the crisis dragged on through winter and into spring and began to destabilise key financial institutions, the policy response focussed on providing liquidity rather than the solvency of the banks and their borrowers.

In this view, banks were basically sound and the deterioration in asset quality was relatively minor. Toxic subprime loans were only a small part of total balance sheets.

Fire-sale prices for a growing number of assets reflected the lack of buyers amid heightened uncertainty, not their fundamental value. If sufficient liquidity could be created, and mark-to-market accounting rules eased, institutions could hold assets to maturity and realise their much higher intrinsic value.

The Fed responded by trying to organize takeovers for troubled institutions and providing a dizzying array of liquidity facilities on an unprecedented scale. The effort culminated with the creation of the US Treasurys Troubled Asset Relief Program (TARP). TARP was designed as a buyer of last resort for illiquid but supposedly valuable assets, able to stabilise the market and aid price discovery by paying more than fire-sale prices and closer to the intrinsic hold-to-maturity value.

The Wall Street first strategy focussed on rescuing the banking system in order to keep credit flowing to consumers and businesses on Main Street. At no point did anyone admit the crisis of liquidity was in fact a crisis of solvency (too much debt and insufficient cashflow). Meanwhile, default rates on residential mortgages continued to climb, unemployment rose and the slowdown spread from housing and motor manufacturing to the rest of the economy.

The first hint of a reassessment came with the Treasurys decision to re-program TARP funds from buying distressed assets to injecting capital into the banks. It was the first indication of growing concern about solvency rather than just liquidity. But the Fed and Treasury continued their focus on Wall Street first, hoping that capital injections and reserve creation would lead to a resumption of lending and forestall a deep contraction. It has not worked.

Altered focus, new hope

In recent weeks, the dramatic failure of a series of high-profile financial institutions, mounting panic about the outlook, and clear signs businesses and households were beginning to cut spending sharply in anticipation of a depression-like drop in sales and employment next year have forced a much more dramatic reassessment.

Priority has shifted from monetary policy and financial system liquidity to fiscal policy and sustaining the real economy.

Perhaps the single most important shift is the deftness with which President-elect Barack Obama has handled the issue. By moving quickly to appoint an economic team of experienced heavyweights and announcing a stimulus package aimed at saving or creating 2.5 million jobs over two years, the incoming president has projected a calm confidence under fire and signaled an appreciation of the need to forestall a deep recession on Main Street.

Quick moves to fill the key posts, an assured performance at three press conferences in three days, and a bold but simple plan that looks big enough to make a difference but is easy to explain and communicate have given the impression fiscal policy is not ineffective and will make a difference. That in turn should blunt some of the pervasive fear and retrenchment spreading through the economy like a virus.

Confidence is an ephemeral commodity, but in a crisis it is the most important one. Repeated failures to stabilise the economy despite upbeat assurances have badly damaged the credibility of the existing Treasury and Fed teams. The presidential transition offers the possibility of a fresh start (much as Franklin Roosevelts transition offered one in 1933).

Some of the new appointees (Timothy Geithner for Treasury secretary and Lawrence Summers for the White House National Economic Council) are closely associated with policies of the last decade that are now coming under scrutiny. Details of the stimulus are sketchy. But the change of cast is more important at present.

Unconventional strategies

Changed atmospherics have been buttressed by practical changes, most importantly at the Fed. The direct lending efforts announced on Tuesday (purchases of Fannie Mae and Freddie Mac bonds on the open market, and lending money to other institutions to buy securitized consumer, auto and credit card loans) offer a reasonable prospect of restoring some credit growth. They should make the Feds quantitative easing strategy effective and unblock the credit creation process.

More importantly, by buying GSE bonds on the open market and lending to others to buy more exotic asset-backed paper, the Fed is engaging in precisely the type of unconventional open market operations in a wider range of securities and maturities that could limit borrowing rates for households and corporations across the economy.

The use of unconventional operations to act on different parts of the yield curve and credit spreads has been discussed in the past as the ultimate response to a crisis. For the first time the Fed is putting it into practice.

Monetary policy is now supporting fiscal policy. Through its aggressive quantitative easing, the Fed has convinced investors short-term interest rates will remain low for an extended period. As a result it has managed to drag the yield on ten-year Treasury securities down from almost 4% to a little over 3%, achieving a key objective.

Lower yields should in turn make it much easier for the US Treasury to get away the vast mountain of bills that need to be refunded and carry out the massive borrowing needed to fund the Obama administrations massive stimulus programme.

Similar reinforcing shifts in fiscal and monetary policy worldwide suggest senior policymakers share a common view of the problem and are adopting mutually reinforcing solutions.

None of this implies that the next 12-24 months will be easy. Continued adjustments will be painful (including a further shrinkage in the capacity of the financial services industry, and restructuring of U.S. motor manufacturing).

The economy will experience its deepest recession since 1979-1981. In the short term conditions look set to worsen further, and the crisis will leave a legacy of enormous public debt.

But provided the incoming administration can tailor an appropriate and credible stimulus package (that delivers front-loaded spending on labor-intensive items) and the Fed is able to support it by keeping long-term rates low and gradually compressing credit spreads, there does appear to be a way to ensure this a recession rather than a slump.